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Professional Judgment In Accounting Service Lines
Dr. Jonathan Grenier and Dr. Andrew Reffett
Miami University
Farmer School of Business
Department of Accountancy
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Miami University | Farmer School of Business | Department of AccountancyDr. Jonathan Grenier and Dr. Andrew Reffett
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Module Overview
· Day 1: Overview of professional judgment
· Day 2: Professional judgment in auditing
· Day 3: Professional judgment in taxation
· Day 4: Professional judgment in advisory services
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Day 1:Overview of professional judgment
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Miami University | Farmer School of Business | Department of AccountancyDr. Jonathan Grenier and Dr. Andrew Reffett
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Agenda
· Kick Off Group Activity– Identifying judgmental areas in the financial statements of
a real-world company· Why do accountants not always exercise good professional
judgment?– Relevant findings from the psychology literature
· Exercising sound professional judgment– Illustrative example with KPMG Professional Judgment
Framework
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Day 1: Overview of professional judgment
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Miami University | Farmer School of Business | Department of AccountancyDr. Jonathan Grenier and Dr. Andrew Reffett
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Kick Off Group Activity
· KPMG LLP (2011) defines professional judgment as “the process of reaching a decision or drawing a conclusion where there are a number of possible alternative solutions.”– Examples: evaluating evidence, estimating probabilities,
choosing between alternatives· Examine Proctor and Gamble’s financial statements.· Identify any financial statement captions that you feel require
significant professional judgment.
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Day 1: Overview of professional judgment
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Miami University | Farmer School of Business | Department of AccountancyDr. Jonathan Grenier and Dr. Andrew Reffett
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The Procter & Gamble Company
Consolidated Balance Sheets
Amounts in millions; June 30 2013 2012
Assets
Cash and cash equivalents $ 5,947 $ 4,436
Accounts receivable 6,508 6,068
INVENTORIES
Materials and supplies 1,704 1,740
Work in process 722 685
Finished goods 4,483 4,296
Total inventories 6,909 6,721
Deferred income taxes 948 1,001
Prepaid expenses and other current assets 3,678 3,684
TOTAL CURRENT ASSETS 23,990 21,910
NET PROPERTY, PLANT AND EQUIPMENT 21,666 20,377
GOODWILL 55,188 53,773
TRADEMARKS AND OTHER INTANGIBLE ASSETS, NET 31,572 30,988
OTHER NONCURRENT ASSETS 6,847 5,196
TOTAL ASSETS $ 139,263 $ 132,244
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Miami University | Farmer School of Business | Department of AccountancyDr. Jonathan Grenier and Dr. Andrew Reffett
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The Procter & Gamble Company
Consolidated Balance Sheets
Amounts in millions; June 30 2013 2012
Liabilities and Shareholders’ Equity
Accounts payable $ 8,777 $ 7,920
Accrued and other liabilities 8,828 8,289
Debt due within one year 12,432 8,698
TOTAL CURRENT LIABILITIES 30,037 24,907
LONG-TERM DEBT 19,111 21,080
DEFERRED INCOME TAXES 10,827 10,132
OTHER NONCURRENT LIABILITIES 10,579 12,090
TOTAL LIABILITIES 70,554 68,209
SHAREHOLDERS’ EQUITY
Convertible Class A preferred stock, stated value $1 per share (600 shares authorized) 1,137 1,195
Non-Voting Class B preferred stock, stated value $1 per share (200 shares authorized) — —
Common stock, stated value $1 per share (10,000 shares authorized; shares issued: 2013 – 4,009.2, 2012 – 4,008.4) 4,009 4,008
Additional paid-in capital 63,538 63,181
Reserve for ESOP debt retirement (1,352) (1,357)
Accumulated other comprehensive income (loss) (7,499) (9,333)
Treasury stock, at cost (shares held: 2013 – 1,266.9, 2012 – 1,260.4) (71,966) (69,604)
Retained earnings 80,197 75,349
Non-controlling interest 645 596
TOTAL SHAREHOLDERS’ EQUITY 68,709 64,035
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY $ 139,263 $ 132,244
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Miami University | Farmer School of Business | Department of AccountancyDr. Jonathan Grenier and Dr. Andrew Reffett
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The Procter & Gamble Company
Consolidated Balance Sheets
Amounts in millions except per share amounts; Years ended June 30 2013 2012 2011
NET SALES $ 84,167 $ 83,680 $ 81,104
Cost of products sold 42,428 42,391 39,859
Selling, general and administrative expense 26,950 26,421 25,750
Goodwill and indefinite lived intangibles impairment charges 308 1,576 —
OPERATING INCOME 14,481 13,292 15,495
Interest expense 667 769 831
Interest Income 87 77 62
Other non-operating income/(expense), net 942 185 271
EARNINGS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES 14,843 12,785 14,997
Income taxes on continuing operations 3,441 3,468 3,299
NET EARNINGS FROM CONTINUING OPERATIONS 11,402 9,317 11,698
NET EARNINGS FROM DISCONTINUED OPERATIONS — 1,587 229
NET EARNINGS 11,402 10,904 11,927
Less: Net earnings attributable to non-controlling interests 90 148 130
NET EARNINGS ATTRIBUTABLE TO PROCTER & GAMBLE 11,312 10,756 11,797
BASIC NET EARNINGS PER COMMON SHARE:
Earnings from continuing operations $ 4.04 $ 3.24 $ 4.04
Earnings from discontinued operations — 0.58 0.08
BASIC NET EARNINGS PER COMMON SHARE 4.04 3.82 4.12
DILUTED NET EARNINGS PER COMMON SHARE:
Earnings from continuing operations $ 3.86 $ 3.12 $ 3.85
Earnings from discontinued operations — 0.54 0.08
DILUTED NET EARNINGS PER COMMON SHARE 3.86 3.66 3.93
DIVIDENDS PER COMMON SHARE $ 2.29 $ 2.14 $ 1.97
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Day 1: Overview of professional judgment
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Judgment on the Balance Sheet (Assets)
· Valuation of accounts receivable– Determining the allowance for doubtful accounts
· Valuation of inventory– Assessing obsolescence, lower of cost or market
· Valuation of deferred tax assets– Assessing whether the assets will be able to be realized
· Valuation of property, plant, and equipment– Identifying and calculating impairments
· Valuation of goodwill, intangibles, and trademarks– Determining fair value
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Judgment on the Balance Sheet (Liabilities/Equity)
· Valuation of accrued liabilities– Warranty reserve– Litigation exposure– Pension obligations– Contingencies
· Completeness of non-controlling interest– Which entities require consolidation?
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Judgment on the Income Statement
· Occurrence of revenue– Has revenue been earned?
· Classification of Expenses· Effects of balance sheet judgments
– Valuation/completeness of impairment charges– Valuation/completeness of bad debt expense
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Summary – Group Activity
· Preparing financial statements requires considerable professional judgment– Determining appropriate accounting methods– Valuing assets and liabilities
· Fair value and principles-based standards have significantly increased the amount of judgment required.
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Day 1: Overview of professional judgment
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Why do accountants not always exercise good professional judgment?
· Heuristics and biases· Judgment traps· External factors/pressures· Not utilizing a good judgment process
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Heuristics and Biases
· Heuristics are mental shortcuts that makes the judgment process more efficient and less cognitively demanding.– Can lead to biased judgment
· Biases are systematic errors in judgment resulting from use of heuristics and/or the influence of external factors.
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3 General Heuristics
· Availability– Overweighting easily retrievable information (e.g., first
thing that comes to mind)– Example: Which is more likely, dying from a shark attack or
from a falling airplane part?· Answer: Falling airplane parts (Read, 1995)
· Representativeness – Overestimating the probability that an item belongs to a
population based on the extent that the item shares representative properties of the population
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3 General Heuristics (continued)
– Example: Estimating the probability that a person seen on campus wearing a backpack that looks about 20 years old is a student.
· Anchoring and Adjustment– Insufficiently adjusting away from an initial anchor– Example: A piece of paper is folded in half. It is folded in
half again, and again. After 100 folds, how thick will it be?· Answer: 1.27 x 1023 kilometers (Plous, 1993)
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Other Heuristics and Biases
· Halo Effect– Basing assessments of specific individual attributes on
their overall assessment of a person or thing· Dilution Effect
– The perceived importance of relevant information is diminished by the presence of irrelevant information.
· Overconfidence– Unwarranted confidence in one’s ability to make a decision
· Self-Serving Biases– The tendency to make judgment and decisions that are
consistent with one’s self-interest
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Other Heuristics and Biases (continued)
· Confirmation bias– Gathering and overweighting (underweighting) evidence
that confirms (disconfirms) one’s beliefs
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Class Discussion Point
· How could the following heuristics and biases affect the judgment of which college to attend?– Availability– Representativeness– Anchoring and adjustment– Halo effect– Dilution effect– Overconfidence– Self-serving biases– Confirmation Bias
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Day 1: Overview of professional judgment
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Judgment Traps
· Rush to solve· Solving the wrong problem· Judgment triggers
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Day 1: Overview of professional judgment
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External Factors/Pressures
· Regulatory pressures– Accounting regulators (e.g., SEC, PCAOB, IRS)– Industry-specific regulators (e.g., utilities, financial
services) · Stakeholder pressures
– Customers, lenders, suppliers, industry organizations– NGOs
· Time pressure
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What is a good judgment process?
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KPMG Professional Judgment Framework
ENVIRONMENT
1Clarify
Issues & Objectives
2Consider Alterna-
tives3Gather & Evaluate Informa-
tion
4Reach Conclu-
sion
5Articulate
& Document Rationale
Knowledge/Professional Standards
Influences/Biases
Reflect onLessons Learned
CoachingCoachingReflect on
Previous Experience
Strategies for Avoiding Traps and Mitigating Bias
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Day 1: Overview of professional judgment
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Components of the Framework
· Knowledge/professional standards· Influences/biases· Strategies for avoiding traps and mitigating bias· Mind-set· Coaching/experience· Consultation· Steps in judgment process
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Knowledge/Professional Standards
· Knowledge of the alternatives, the decision context, and professional standards foster high-quality professional judgment.– Business knowledge– Industry knowledge– Generally Accepted Accounting Principles (GAAP)– Generally Accepted Auditing Standards (GAAS)· PCAOB Auditing Standards
– IRS Code
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Influences/Biases
· As previously discussed, heuristics and biases can compromise professional judgment.
· The KPMG Professional Judgment Framework identifies several strategies for avoiding traps (e.g., use of heuristics) and mitigating bias.
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Day 1: Overview of professional judgment
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General Strategies for Avoiding Traps and Mitigating Bias
· Training Awareness of heuristics and biases· Decision support tools
– Judgment frameworks and those tailored to specific accounting judgments
· Group decision making· Quality control procedures
– Example: Hierarchical review· Consultation (more to come)· Documentation (more to come)
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Strategies for Specific Heuristics/Biases
· Availability– Consider why something
comes to mind– Consider alternative
explanations– Consult
· Confirmation– Consider alternative
explanations– Consider disconfirming
evidence
· Anchoring
– Develop an independent judgment without an anchor
– Consider alternative anchors
– Consult without giving him or her an anchor
· Overconfidence
– Challenge expert/advisor estimates
– Challenge extremely low or high estimates
– Challenge underlying assumptions
Note: Awareness of the tendency is critical for mitigating all biases.
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Day 1: Overview of professional judgment
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Mind-set
· Judgment framing– What frame are we using? – Challenge your current frame.– Are there alternative frames?
· Professional skepticism– Questioning mind and critical evaluation of evidence– Trust but verify
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Coaching/Experience
· Coaching should be the beginning and end of the judgment process, but also conducted throughout the process.– Help others that are about to make a judgment– Learn from experience· Avoiding future mistakes· Reinforcing good judgment habits
· KPMG Professional Judgment Framework provides common vocabulary to facilitate coaching.
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Day 1: Overview of professional judgment
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Consultation
· Informal consultation
– Ask colleagues who may have made similar judgments.
– Try to find colleagues that have arrived at different conclusions for similar judgments.
– Avoid confirmation bias if you know that a colleague will likely tell you the answer you want to hear.
· Formal consultation
– Companies can hire consultants or get advice from accounting firms.
– Public accounting firms have formal consultation processes for important auditing and tax judgments.· Often, consultation is even required.
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Steps in Judgment Process
1Clarify
Issues & Objectives
2Consider
Alternatives
3Gather & Evaluate
Information
4Reach
Conclusion
5Articulate & Document Rationale
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Clarify Issues and Objectives
· Issues: What is the problem to be solved?· Objectives: What is wanted or needed?
Application: Choice of colleges
When you were making this extremely important judgment, what were the issues and objectives?
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Consider Alternatives
· Judgment is only as good as the best alternative considered.· People often do not consider all alternatives.
– Only consider typical alternatives– Only consider the first alternative that comes to mind
· It is important to brainstorm and search (e.g., research, consult others) for all potential alternatives.
Application: Choice of colleges– What are the alternatives?
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Gather and Evaluate Information
Gathering· Gather an appropriate amount of information
– Both confirming and disconfirming· Consider the information’s reliability, validity, and accuracy
Evaluating· Compare alternatives using the gathered information· Consider consequences of the alternatives
Application: Choice of colleges– What information did/would you gather?
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Gather and Evaluate Information (continued)
– How much is appropriate?– What information could be unreliable, invalid, or
inaccurate?– What are the consequences of the various alternatives?
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Reach Conclusion
· Make a case for the conclusion, and cases for the alternatives.
· Does the conclusion make sense from a big-picture perspective?
· Is the conclusion supported by the evidence? If not, what additional evidence is needed?
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Articulate and Document Rationale
· In many accounting and other professional contexts, documentation is critically important.– Facilitate the internal review process– PCAOB inspections– Litigation protection
· Documenting rationale also helps identify potential weaknesses and/or areas where more evidence is needed.
· Documentation needs to address disconfirming evidence.
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Day 1 Summary
· Judgment is pervasive in accounting.· There are many factors (e.g., heuristics and biases, external
pressures) that make it difficult to exercise good professional judgment.
· The KPMG Professional Judgment Framework provides guidance and a specific process for making good professional judgments.
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Day 1: Overview of professional judgment
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Day 2: Professional judgmentin auditing
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Agenda
· Important auditing judgments· Heuristics and biases in auditing· Application of KPMG Professional Judgment Framework to
an auditing issue
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Day 2: Professional judgment in auditing
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Examples of Important Auditing Judgments
· Client acceptance and retention· Assessing the risk of material misstatement· Establishing planning materiality· Planning the audit· Analyzing audit evidence
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Day 2: Professional judgment in auditing
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Client Acceptance and Retention
· Is the firm capable of performing the audit?– Expertise– Resources– Independence– Availability of audit evidence
· Is it in the firm’s interest to perform the audit?– Profitability of the engagement– Other benefits· Fees from other services that could be sold to the client;
reputation enhancement (glamor client) attracting other clients
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Day 2: Professional judgment in auditing
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Client Acceptance and Retention (continued)
– Other costs· Opportunity costs, reputation degradation (questionable
client) loss of other clients– Auditors’ business risk (i.e., litigation exposure)
· Consequences of poor judgment– Accepting client that an audit firm is not capable of auditing
(e.g., due to a lack of firm expertise in a particular industry)· High risk of future lawsuits, regulatory penalties, and
impaired reputation– Accepting clients that are not in the firm’s best interest to
audit
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Client Acceptance and Retention (continued)
· High risk of future lawsuits, regulatory penalties, and impaired reputation
· Unprofitable engagements– Rejecting good prospective clients· Revenue loss· Potential reputational damage
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Assessing the Risk of Material Misstatement
· In audit planning, auditors assess the risk of a material misstatement at the account level and plan their audit accordingly.– High risk accounts extensive and highly reliable audit
procedures– Low risk accounts less extensive and less reliable audit
procedures· Considerations
– Accounts’ susceptibility to intentional or unintentional misstatements (e.g., complexity, management integrity/competence, pressure)
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Assessing the Risk of Material Misstatement (continued)
– Effectiveness of internal controls at preventing or detecting material misstatements.
· Consequences of poor judgment– Assessing RMM too high: inefficient audits· Devoting too much effort to low risk accounts· Drives up cost of the audit
– Assessing RMM too low: ineffective audits· Not devoting enough effort to high risk accounts· Higher likelihood of missing a material misstatement and
issuing an inappropriate opinion.
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Establishing Planning Materiality
· Auditors design their audit to detect material misstatements.· Materiality is based on the auditors’ assessment of the
magnitude of a misstatement that would affect the decisions of a reasonable financial statement user.
· Materiality is often calculated as a percentage of net sales, total assets, and/or net income, but is often adjusted for qualitative/judgmental factors:– Nature of the misstatement (e.g., error vs. fraud)– Account misstated (e.g., revenue vs. fixed assets)– Does the misstatement result in the client missing an
earnings benchmark or violating a loan covenant?
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Establishing Planning Materiality (continued)
· Consequences of poor judgment– Assessing materiality too high: ineffective audits· Performing a less extensive audit than necessary· Failing to detect misstatements that reasonable users
deem material · Deeming detected misstatements immaterial that
reasonable users deem material, and fail to amend their audit opinion accordingly.
· High probability of an inappropriate opinion– Assessing materiality too low: inefficient audits· Performing a more extensive audit than necessary· Drives up cost of the audit
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Planning the Audit
· After assessing RMM and materiality, auditors must staff engagements and determine the nature, timing, and extent of audit procedures.– Staffing: experience, expertise– Nature: reliability of audit procedures– Timing: interim vs. year-end– Extent: how many procedures, sample sizes
· Consequences of poor judgment– Too-thorough audit procedures inefficient audits– Insufficiently thorough audit procedures ineffective audits
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Analyzing Audit Evidence
· Auditors must determine if the evidence obtained provides a reasonable basis for an opinion on the material accuracy of the financial statements.
· Consequences of poor judgment– Requiring too much evidence inefficient audits– Not requiring enough evidence ineffective audits· High likelihood of an unqualified opinion on materially
misstated financial statements· Possibility of litigation, regulatory penalties, and
reputational damage
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Heuristics and Biases in Auditing
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Heuristics and Biases in Auditing
· Self-serving biases· Biases due to expectations
– Confirmation bias– Halo effect
· Biases due to reliance on heuristics– Representativeness– Dilution effect– Anchoring and adjustment
· Overconfidence
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Self-serving Biases
· Auditor judgment can be biased in a manner consistent with their self-interest. Typically, this means that the auditor will be more likely to judge client-preferred accounting methods as appropriate for several reasons making self-serving bias highly detrimental to audit quality and the fulfillment of auditors’ professional obligations:– The auditor does not want to jeopardize future revenues by
upsetting management.– Long-tenured auditors develop friendships with
management.
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Self-serving Biases (continued)
· Negative consequences associated with upsetting management are more salient and immediate than the delayed, potentially never-realized consequences of issuing an inappropriate audit opinion.
· Substantial estimation in financial statement creates substantial room for bias.
· Self-serving bias is often unconscious where the auditor does not realize that he or she is being influenced by self-interest.
· Identifying problems could lead to working longer hours and potential budget overruns.
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Self-serving Biases (continued)
· Auditors are also more likely to reach conclusions that are consistent with supervisor (e.g., partner) preferences.
· Due to budgetary pressures, this could lead to underassessments of RMM, overassessments of materiality, less thorough audits, and therefore, ineffective audits.
· The Sarbanes-Oxley Act of 2002 has several provisions designed to mitigate self-serving bias.– The audit committee, rather than client management, hires
and fires the auditors.– Audit partners must rotate every 5 years.
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Self-serving Biases (continued)
– Many nonaudit services cannot be provided by the auditors.
· Nevertheless, auditors should be aware that their self-interest can bias their judgment.
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Confirmation Bias
· Auditors often subconsciously search for and overweight evidence that is consistent with their expectations.
· Example: Preliminary Analytical Review– A client’s inventory has significantly increased.– The client has not had a misstatement in several years.– The auditors are more likely to search for and overweight
nonmisstatement explanations (e.g., rise in raw material cost) for the inventory increase.
– In this case, confirmation bias could result in underassessment of RMM for inventory, and ultimately, failing to detect a misstatement.
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Confirmation Bias (continued)
· To mitigate confirmation bias, auditors should:– Be aware of potential bias– Exercise professional skepticism– Actively seek out potential disconfirming evidence
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Halo Effect
· Auditors’ judgments about specific attributes of management can be influenced by their overall assessment of the organization.
· If an auditor has an overall positive (negative) view of an organization, the halo effect could lead to under (over) assessments of RMM and fraud risk, and thus, ineffective (inefficient) audits.
· The halo effect could also be due to nondiagnostic factors such as the client’s philanthropic efforts, CEO/CFO education/religion, etc.
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Halo Effect (continued)
· To mitigate the halo effect, auditors should:– Be aware of their overall impressions, and the fact that
they might influence their judgments.– Exercise professional skepticism
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Representativeness and Dilution Effect
· Auditors can over (under) estimate the probability that an item belongs to a population based on the extent that the item shares (does not share) representative properties of the population.
· Auditors may underestimate the importance of relevant information in the presence of irrelevant information.
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Representativeness and Dilution Effect (continued)
· Example: Auditor’s assessment of the risk of asset misappropriation is influenced by the extent to which the auditor considers the CFO to share representative properties with the auditors’ conception of people who misappropriate assets. Judgment errors can occur when:
– Auditors do not consider or do not know relevant information (e.g., unaware of CFO gambling habit).
– Auditors consider irrelevant information (e.g., aware of CFO gambling habit, but also consider how nice the CFO has always been to the auditors).
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Representativeness and Dilution Effect (continued)
– Auditors’ conceptualization of the item (e.g., what type of people misappropriate assets) is inaccurate.
– Auditors ignore base-rate information about the item (e.g., underestimate the base-rate of asset misappropriation).
· To avoid judgment errors, auditors should:– Be aware that their conceptualizations of items and
irrelevant information can influence their judgments.– Attempt to gather all relevant information– Attempt to identify all irrelevant information· So that it can be set aside and not affect judgment
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Anchoring and Adjustment
· Auditors’ judgments can be influenced by anchors such as:– Prior client performance– Unaudited financial statement balances
· Adjustments away from such anchors tend to be insufficient.· Example: Warranty reserve
– A company experiencing product failures sets up a small warranty reserve.
– When considering evidence that the reserve should be higher, auditors are likely to insufficiently adjust from the anchor.
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Anchoring and Adjustment (continued)
· To avoid judgment errors, auditors should:– Be aware of potential anchors– Try to avoid being exposed to potential anchors before
developing expectations (e.g., unaudited balances)– Consider alternative anchors– Consult with others (without providing an anchor)
Source: KPMG (2011)
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Overconfidence
· Auditors can be overconfident in almost any judgment. Examples include:– Client acceptance– Materiality and risk assessment– Audit planning– Knowledge of industry, GAAP, GAAS
· To avoid judgment errors, auditors should:– Be aware of the potential for overconfidence– Exercise professional skepticism, including self-criticism
(Bell et al. 2005)
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Application of KPMG Professional Judgment Framework
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KPMG Professional Judgment Framework
ENVIRONMENT
1Clarify
Issues & Objectives
2Consider Alterna-
tives3Gather & Evaluate Informa-
tion
4Reach Conclu-
sion
5Articulate
& Document Rationale
Knowledge/Professional Standards
Influences/Biases
Reflect onLessons Learned
CoachingCoachingReflect on
Previous Experience
Strategies for Avoiding Traps and Mitigating Bias
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Knowledge
· The entity– Ownership structure, governance, related-party
transactions– Business objectives and strategy – Operating, investing, and financing activities– Accounting policies– Internal control– Recent financial performance
· Its environment– Industry, regulatory, and other external factors– Business risks with implications for going concern and risk
of material misstatement
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Influences
· Time Pressure – could help focus the auditors on critical audit tasks, but also make them less likely to recognize indicators of increased risk.– Budgetary pressure– Client-imposed deadlines
· Regulatory – Auditors of public companies are subject to inspections by the PCAOB. Judgments could be affected by known regulator concerns.
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Other Elements of the Framework
· Coaching – important to reflect on lessons learned and help others– Hierarchical review is required in auditing.– Mentoring is also very common.
· Mind-set– Professional skepticism– Awareness of judgment traps and biases
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Professional Standards
· GAAP/IFRS– The external criteria that you are verifying that the client’s
financial statements are compliant with· GAAS
– Auditing standards applicable to audits of nonpublic companies
· PCAOB Auditing Standards– Auditing standards for audits of public companies
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Illustration of 5-Step Process – Assessing Planning Materiality
Step 1: Clarify issues and objectives· Issue: determining the amount of a misstatement that could
impact the decision of a well-informed, reasonable financial statement user.
· Objective: Accurately assess planning materiality (i.e., not too low or too high)
Step 2: Consider alternatives· Auditors typically use percentages of pre-tax income (5 –
10%), total revenues (0.5 – 1.0%), or total assets (0.5 – 1.0%).
· Consider different frames (i.e., perspectives of different user groups)
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Illustration of 5-Step Process – Assessing Planning Materiality (continued)
Step 3: Gather and evaluate information· Relevant professional auditing standards· Primary groups of financial statement users· Specific client attributes (e.g., proximity to relevant earnings
benchmarks)· Consequences of too low or too high level of planning
materiality
Step 4: Reach a conclusion· Does the conclusion make “big picture” sense?· Is the conclusion supported by the evidence?· Consult with colleagues
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Illustration of 5-Step Process – Assessing Planning Materiality (continued)
Step 5: Articulate and document rationale· Document professional standards and alternatives
considered.· Documentation provides legal/regulatory protection and
facilitates the internal review process.
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Day 3:Professional judgmentin taxation
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Agenda
· Important taxation judgments· Heuristics and biases in taxation· Application of KPMG Professional Judgment Framework to a
taxation issue
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Examples of Important Taxation Judgments
· Determining what constitutes a deductible business expense· Assessing the probability of success of a particular tax
position· Valuation of a business or partnership upon death· Allocating costs of property purchases between buildings and
land· When is an activity a hobby or a for-profit endeavor?
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Determining What Constitutes a Deductible Business Expense
Clearly ordinary and necessary
Mileage costs for driving to meeting potential customers
Clearly not ordinary and necessary
Helicopter rental costs for flying to meet potential customers
Unclear whether ordinary and necessary
Lavish meals for entertaining potential customers
· Self-employed taxpayers have certain expenses that require the tax preparer to exercise judgment as to whether or not they are a deductible business expenses. Taxpayer must determine if the expenses are ordinary and necessary.
· Consequences of poor judgment
– Improper classification as a nonbusiness expense: higher taxable income
– Improper classification as a business expense: penalties, fines, interest, and potentially criminal charges
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Assessing the Probability of Success of a Particular Tax Position
· When preparing returns, tax practitioners should believe that a particular tax position is more likely than not to be supported if reviewed by the applicable tax authority.
· To make this judgment, tax preparers should consider:– Applicable tax code– Relevant legal precedents– Their own experience with the tax authority
· Overestimation of the probability of a tax position being upheld could lead to penalties, fines, interest, and in extreme cases, criminal charges for both the taxpayer and practitioner.
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Valuation of a Business or Partnership Upon Death
· Tax practitioners must determine the value of a deceased person’s partnership or business in order to calculate the value of his/her estate.
· Significant judgment is required to determine the market value of the entity’s tangible and intangible assets.
· Consequences of poor judgment– Overvaluation paying too much estate tax– Undervaluation penalties, fines, interests, and potential
criminal charges
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Allocating Costs of Property Purchases Between Buildings and Land
· When a property is purchased, tax practitioners must use judgment to determine how the purchase price should be allocated between buildings and land.
· Major tax implication as buildings are depreciable and land is not.
· Consequences of poor judgment– Overallocation to land: overpayment of tax– Overallocation to buildings: underpayment of tax and thus
penalties, fines, interest, and potential criminal charges.
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When is an Activity a Hobby or a For-Profit Endeavor?
· Certain activities are hobbies for most people, but for-profit endeavors for others (e.g., race horses, gambling, arts and crafts).
· Hobby losses cannot be deducted, but for-profit losses can.· When making this judgment, tax practitioners should
consider:– The time and effort devoted to the activity– Taxpayer reliance on income from the activity– Sources of the losses (e.g., start-up costs)– Taxpayer knowledge to run successful business
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Heuristics and Biases in Taxation
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Heuristics and Biases in Taxation
· Self-serving biases· Overconfidence· Confirmation bias· Anchoring and adjustment
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Self-serving Biases
· To keep clients satisfied, tax practitioners are motivated to minimize their client’s taxable income. Thus, tax practitioners may be more likely to:– Consider business expenses ordinary and necessary– Undervalue a business or partnership– Consider an activity to be a for-profit endeavor– Overallocate purchase costs to buildings– Determine that a given position is more likely than not to be
upheld by tax authorities· To avoid judgment errors, tax practitioners should be:
– Aware of the potential for self-serving bias– Consult with others on important judgments
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Overconfidence
· Tax practitioners can be overconfident in almost any judgment.
· Subconsciously searching for and overweighting preference-consistent information (i.e., motivated reasoning due to self-serving biases) exacerbates overconfidence.
· To avoid judgment errors, tax practitioners should:– Be aware of potential overconfidence– Be self-critical– Consult with others on important judgments
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Day 3: Professional judgment in taxation
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Confirmation Bias
· Tax practitioners have expectations regarding the results of their research, and are more (less) likely to gather and overweight (underweight) evidence that confirms their expectations.
· Example: When expecting that a certain expense is deductible, tax practitioners may be drawn to cases where similar expenses were deductible, and not cases where similar expenses were deemed nondeductible.
· To avoid judgment errors, practitioners should:– Be aware of potential bias– Actively seek disconfirming evidence – Consult with others on important judgments
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Day 3: Professional judgment in taxation
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Anchoring and Adjustment
· Tax practitioners are susceptible to insufficient adjustments away from numerous potential anchors including:– Client-reported revenue and expenses– 50 percent probability threshold in determining acceptability
of a given position– Legal precedents
· To avoid judgment errors, tax practitioners should:– Be aware of and try to avoid exposure to potential anchors– Consider alternative anchors– Consult with others (without providing an anchor)
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Day 3: Professional judgment in taxation
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Application of KPMG Professional Judgment Framework
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KPMG Professional Judgment Framework
ENVIRONMENT
1Clarify
Issues & Objectives
2Consider Alterna-
tives3Gather & Evaluate Informa-
tion
4Reach Conclu-
sion
5Articulate
& Document Rationale
Knowledge/Professional Standards
Influences/Biases
Reflect onLessons Learned
CoachingCoachingReflect on
Previous Experience
Strategies for Avoiding Traps and Mitigating Bias
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Day 3: Professional judgment in taxation
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Knowledge
· The entity– Tax status, ownership structure, governance, related-party
transactions– Tax jurisdictions– Business objectives and strategy – Operating, investing, and financing activities– Accounting/tax policies
· Its environment– Industry, regulatory, and other external factors
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Influences
· Time Pressure– Budgetary pressure– Filing deadlines (e.g., April 15 for individual returns)– If time pressure is significant and compromises judgment,
tax practitioner should consider filing extensions.· Regulatory/Industry
– Regulators in certain industries may offer tax credits or exert pressure for certain tax positions.
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Other Elements of the Framework
· Mind-set– Awareness of potential heuristics and biases while
maintaining advocacy role· Coaching – important to reflect on lessons learned and help
others– Hierarchical review – Mentoring
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Professional Standards
· IRS Code– And international codes when working across international
jurisdictions· Legal precedents
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Illustration of 5-Step Process – Deducting Home Office Expenses
Step 1: Clarify issues and objectives· Issue: Whether or not to deduct costs associated with a
home office as an expense on client’s tax return.· Objectives: (1) Report as low of income as possible (to
minimize client tax liability) without increasing the risk of an IRS audit and resulting penalties, fines, interest, and/or criminal charges. (2) Deduct (do not deduct) all expenses that are (not) more likely than not to be upheld by the IRS.
Step 2: Consider alternatives.
1.Deduct all of the expenses associated with the home office.
2.Deduct some of the expenses associated with the home office.
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Illustration of 5-Step Process – Deducting Home Office Expenses (continued)
3.Deduct none of the expenses associated with the home office.
4.Others?
Step 3: Gather and evaluate information· Determine the precise nature of the home office and
associated costs.– How is the space used for business?– Is the space used regularly and exclusively for business?– Information about the associated costs
· Reliability of the information· Applicable tax code/law, rulings related to deductibility
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Illustration of 5-Step Process – Deducting Home Office Expenses (continued)
Step 4: Reach a conclusion· Does the conclusion make “big picture” sense?· Is the conclusion supported by the evidence?· Consult with colleagues
Step 5: Articulate and document rationale· Relevant IRS code and rulings· Alternatives considered· Audit protection
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Day 3: Professional judgment in taxation
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Day 4:Professional judgmentin advisory services
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Agenda
· Background on advisory services– Including representative advisory judgments
· Heuristics and biases in advisory· Application of KPMG Professional Judgment Framework to
an advisory issue
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Management Consulting
· IT/ERP– Helping clients implement new IT systems or improve
existing IT systems– Enterprise Resource Planning systems
· Financial Reporting– Consulting on financial reporting decisions– IFRS conversion– Cannot be jointly provided by the client’s auditor
· Taxation– Consulting on tax positions and overall tax strategy
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Management Consulting (continued)
· Many other types of services– Analytics, process management, change management,
outsourcing, strategy
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Risk Consulting/Assurance
· Helping organizations with their overall approach to risk (e.g., Enterprise Risk Management (ERM)) or specific risks (e.g., new regulations)
· Effective ERM should be aligned with organizational strategy and create long-term sustainable value.
· KPMG Global Risk Survey Video: http://www.kpmg.com/US/EN/SERVICES/ADVISORY/RISK-AND-COMPLIANCE/Pages/default.aspx
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Transactions and Restructurings
· Mergers and acquisitions– Identify and evaluate potential acquisitions– IPO guidance– Integrating accounting and IT/ERP systems
· Restructurings– Develop restructuring plans– Divesting of struggling or noncore business units
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Forensic Services
· Implementing/improving fraud prevention programs– Internal controls
· Fraud detection and assessing clients’ risk of fraud– Forensic data analytics
· Investigating and resolving identified cases of fraud– Evidence collection– Legal support (e.g., expert witness, arbitrator)
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Sustainability
· Sustainability reporting
– Help clients develop external sustainability reports
– Facilitate adherence to reporting guidelines such as Global Reporting Initiative's (GRI) G4 standards
· Integrated reporting
– Help integrate sustainability reporting with financial reporting
– Application of International Integrated Reporting Committee (IIRC) framework
· Independent assurance
– Attest to the reliability of external sustainability reporting
– Attest to the quality of client’s stakeholder engagement (AccountAbility1000 guidelines)
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Day 4: Professional judgment in advisory services
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Heuristics and Biases in Advisory
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Heuristics and Biases in Advisory
· Self-serving biases· Confirmation bias· Halo effect· Overconfidence
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Self-serving Biases
· Advisors’ judgment could be self-serving in two primary ways:– Arriving at judgments that are consistent with client
preferences for client satisfaction– Arriving at judgments that result in additional
services/billable hours· Example: IT consulting
– Clients want to hear that their IT system is operating effectively.
– Recommending system improvements could generate fee revenue for the advisor.
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Confirmation Bias
· Advisors are more (less) likely to gather and overweight evidence that confirms (disconfirms) their expectations.
· Example: IT Consulting– Advisors that are evaluating the effective of client
information systems that they expect are strong (weak) are more likely to gather and overweight evidence related to known system strengths (weaknesses).
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Halo Effect
· Advisors’ judgments about specific attributes of an organization could be influenced by their overall assessment of the organization.
· Example: Corporate Social Responsibility– Advisors who are assessing and/or attesting to the quality
of a client’s corporate social responsibility initiatives may be more likely to assess these initiatives as high (low) quality when they have a favorable (unfavorable) overall opinion of the client.
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Overconfidence
· Advisors can be overconfident in almost any of their judgments.– Identification of relevant benchmarking criteria– Selection of proper procedures to perform– Accurate identification of client strengths and weaknesses– Recommendations for improvement are appropriate for the
client.
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Day 4: Professional judgment in advisory services
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Application of KPMG Professional Judgment Framework
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KPMG Professional Judgment Framework
ENVIRONMENT
1Clarify
Issues & Objectives
2Consider Alterna-
tives3Gather & Evaluate Informa-
tion
4Reach Conclu-
sion
5Articulate
& Document Rationale
Knowledge/Professional Standards
Influences/Biases
Reflect onLessons Learned
CoachingCoachingReflect on
Previous Experience
Strategies for Avoiding Traps and Mitigating Bias
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Day 4: Professional judgment in advisory services
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Knowledge
· The issue/purpose of the advisory engagement– External benchmarks/best practices– Similar cases– Business knowledge
· The entity– Ownership structure, governance– Business objectives and strategy – Operating, investing, and financing activities– Internal control– Recent financial performance
· Its environment– Industry, regulatory, and other external factors
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Influences
· Time Pressure– Budgetary pressures– Client-imposed deadlines
· Industry/Regulatory– Certain industries (e.g., utilities, insurance, banking) have
their own regulators that may result in pressures on the advisors to reach particular judgments.
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Other Elements of the Framework
· Coaching/experience– Compile experiences from clients– Assess applicability to current engagement– Help others improve their judgments
· Mind-set– Awareness of heuristics and biases– Willingness to consult with others
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Professional Standards
· No generally accepted advisory standards· Firm-specific methodologies for conducting advisory
engagements· External benchmarking criteria
– CSR/Sustainability: GRI, IIRC, SASB– ERM: COSO and ISO 31000
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Illustration of 5-Step Process – IPO Guidance
Step 1: Clarify issues and objectives· Issue: Should a client seeking to raise capital undertake an
initial public offering?· Objective: Help the client make an informed IPO decision by
educating them on the benefits, costs, and risks associated with an IPO.
Step 2: Consider alternatives· Undertake the IPO in the near future.· Delay or forego the IPO.· Which exchange? NYSE? NASDAQ? International?· Consider alternative funding sources such as debt capital or
a joint venture.
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Illustration of 5-Step Process – IPO Guidance (continued)
Step 3: Gather and evaluate information· Recent IPO performance, especially of similar companies· General stock market conditions· State of client’s accounting, internal control, and IT systems
(i.e., are they prepared for an IPO)· Client’s financial condition and intended use of the equity
capital
Step 4: Reach a conclusion· Should the client undertake the IPO and, if so, what needs to
be done in preparation for the IPO?
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Illustration of 5-Step Process – IPO Guidance (continued)
· Does the conclusion make big picture sense?· Is the conclusion supported by the evidence?
Step 5: Articulate and document rationale· Relevant external benchmarks/best practices· Alternatives considered· Documented guidance for client implementation
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Day 4: Professional judgment in advisory services
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